Can economists contribute anything useful to our understanding of politics, business and finance in the real world?

I raise this question having spent last weekend in Toronto at the annual conference of the Institute for New Economic Thinking, a foundation created in 2009 in response to the failure of modern economics in the global financial crisis (whose board I currently chair). Unfortunately, the question raised above is as troubling today as it was in November 2008, when Britain’s Queen Elizabeth famously stunned the head of the London School of Economics by asking faux naively, “But why did nobody foresee this [economic collapse]?”

As John Maynard Keynes observed in 1936, when he challenged the economic orthodoxies that were aggravating the Great Depression: “The ideas of economists, both when they are right and when they are wrong, are more powerful than is commonly understood. Indeed, the world is ruled by little else. Practical men, who believe themselves to be quite exempt from any intellectual influences, are usually slaves of some defunct economist.”

This remark is as relevant today as in 1936. Joseph E. Stiglitz, the Nobel laureate, asked rhetorically in Toronto: “Why are central banks and governments still trying to predict the effects of their policies with an economic model that is manifestly absurd?”

His answer was that the economic models studied in universities and published in leading academic journals are still largely based on a simplifying concept, known as the Representative Agent, which effectively assumes that “everyone in the economy is the same.” So these models have nothing to say about lending or borrowing, ignore the existence of banks and treat bankruptcies as unimportant because “when the borrower does not repay, he only defaults on himself.”

Amazingly, these economic models with no banks are still the main analytical tool used by most central banks. Peeling away further layers of the theoretical onion reveals something even more bizarre: an inbuilt assumption that the economy is self-stabilizing. This means that virtually any policies the central bank may choose to follow will lead automatically to full employment — in the forecasts, if not in the real world.

The pernicious effects of such stilted thinking are most visible in Europe. As Adair Turner, former chairman of Britain’s Financial Services Authority and now an INET Senior Fellow argued, the rules for the eurozone agreed in 1991 were based on the belief that “economists had cracked the problem of macroeconomics – that low and stable inflation was not just necessary, but sufficient for economic success.”

Making matters worse for Europe, this hubris among economists was combined in the Maastricht Treaty with the German concept of “ordo-liberalism,” which asserted that government’s only legitimate role was to set clear rules for competition and price stability and then strictly enforce them.

“This was why the Bundesbank’s legal department became as powerful as its economic department,” Turner noted, “and why Germany has been so unbending in its interpretation of the euro rules. We now know that ordo-liberalism does not work in macroeconomics. But the entrenchment of these old economic ideas, even after they have been proved wrong, is so great that any change will be very slow.”

As a result, Turner concluded, Europe “could look remarkably like Japan in the 1990s, with many years of very low growth — but probably much greater social tension, because Europe’s immigration-based societies are much less uniform and consensual than Japan’s.”

How could economists break this pernicious grip of old ideas? The obvious answer is by developing new ideas and many were presented at Toronto: Forecasting currencies with a new technique called Imperfect Knowledge Economics developed in New York and Copenhagen; understanding the role of government in technological innovation through work in Cambridge and Massachusetts; analyzing the role of self-fulfilling “reflexive” expectations in boom-bust cycles; applying the mathematics of complex systems to economic problems ranging from financial instability to housing and the competitiveness of developing countries in Oxford and Rome; funding work in Paris and Berkeley on income distribution that is attracting worldwide attention; researching the economics of education and childhood development through a global network led from Chicago; developing new undergraduate courses on subjects neglected by the traditional curriculum with an international team of professors run from University College London and Bangalore; restoring the study of economic history through workshops in Italy and the United States.

But despite such initiatives, the “old ideas that have been proved wrong,” including inflation targets, self-stabilizing markets, and rigid separation of monetary and fiscal policy, remain dominant where they are most dangerous — in the macroeconomic analysis of finance ministries and central banks. Overcoming these old ideas will require new thinking about politics and not just economics.

As Michael Sandel, the Harvard philosopher, told the conference: “Over the past three or four decades, the public life of our societies has been animated by a faith that market mechanisms can answer all questions and solve all problems. This era of unquestioned faith in markets coincided with the time when political life lost the sense of morality or public purpose. Market reasoning seems to offer a non-judgemental way of allocating goods and incomes, but in many cases we have to make moral judgements. The new economic thinking that is now required has many affinities with old economic thinking. Classical economists, going back to Adam Smith, did not view economics as a value-neutral science or even as an autonomous discipline. They all understood economics to be a sub-field of moral and political philosophy.”

In other words, economics always operates in a specific political context. Market mechanisms must be judged by social outcomes, government and business must work in concert, not in opposition. As a new phase of global capitalism emerges from the 2008 crisis, these are the key ideas that economists will have to discover — or rediscover.




Anatole Kaletsky is an award-winning journalist and financial economist who has written since 1976 for The Economist, the Financial Times and The Times of London before joining Reuters. Anatole Kaletsky is chairman of INET’s board of governors, co-chairman of Gavekal Dragonomics, and author of Capitalism 4.0, which develops many of these ideas.